Friday, September 30, 2005

Is This The Sign of a Top?

Thus reads the most interesting headline I’ve seen in today’s Wall Street Journal.

Pros Warn It Might Be Too Late To Capture Big Gains in a Sector That Is Known for High Volatility

By now, with oil defying both gravity and the expectation of most forecasters that oil prices would settle down post-hurricanes, you might expect the press to be getting excited about the stocks.

Instead, the same press that has been calling the housing bubble (as I did in this blog on August 5th, 2005) for 2 years, is saying “stay away.”For people paying hefty prices at the pump these days, it might be tempting to drive straight home -- burning off a bit of that precious gasoline -- and try to make money investing in energy-focused mutual funds.

Don't.

Meanwhile, Venezuela is threatening to seize oil fields and banish foreign oil companies from their rich fields over tax and contract issues.

And Russian oil producer Lukoil just joined India and the China National Petroleum Company in buying up foreign oil producing capacity, making a $2 billion bid for a Kazakhstan producer.

The day after the Kremlin bought yet another major Russian oil producer.

The content contained in this blog represents the opinions of Mr. Matthews. Mr. Matthews also acts as an advisor and clients advised by Mr. Matthews may hold either long or short positions in securities of various companies discussed in the blog based upon Mr. Matthews' recommendations.

Take a look at how analysts value companies nowadays. They assume that PUDs aren't any different than PDPs. Back at the bottom in '99 PUDs were being valued at -0-. Now you see analysts not only value PUDs at full value with 100% certainty, you also see them valuing probable reserves, something that was formerly in the realm of only the penny stock energy companies.

Analysts are reaching, big time, to justify their target prices. In the meantime, you're seeing very real indications that there's serious demand destruction. That is getting zero play except for the one major analyst that doesn't like the group. (The same analyst was pretty much the only one to like the group 5 years ago.) Last time crude prices were at this level, demand dropped, and didn't recover for almost two decades. We're seeing demand drop again. That is not a trend that is easily reversible.

when you say demand destruction, where is it? The problem is that people do not want to admit that the US economy is still heavily oil-dependent; the dependency has just switched to other areas. Its gone from manufacturing to other areas that require larger and larger amounts of energy. Furthermore, people are not in the midst of a recession or a highly inflationary environment like in the 70's, so demand can be kept up with the use of credit.

I do not see any of the deamnd destruction you are talking about. If anything, what will happen if oil prices go down is that demand will increase even more. Chinese and Indian economies are the world's growth engine, and they are heavily dependent on oil.

Call me crazy, but I'm still maximum bullish on energy. I think we have a ways to go; maybe we’re in the top of the fourth inning. This is a demand bull market lead by China. I've been to going to China every few years for over the past decade and it’s kind of scary to think of all those bicycles being traded in for cars.

Regarding demand destruction, high prices will do it, but it takes awhile for this to gain traction and reverse the current trend. It might finally be starting at the consumer level with people trading in their SUV’s. To me though, we’re no where near the level of concern that we had during the peak of our last energy crisis.

As for a top, I don’t like predicting when, why or how, but I’ll throw this out there anyway. It will be something big, like the House of Saud being toppled or Iran / N. Korea lobbing nukes, but I’ve been wrong many times before.

Gasoline: demand since Katrina hit has been consistently down over pre-Katrina levels. We're down from about 9.4mm bbls/day to 8.8mm bbls/day.

Natural gas: we've seen injections higher than expected for 3 weeks now. We're not higher than the 5 year average. The only thing that bailed out the gas market is a much warmer than normal summer. Ex out the weather factor, and net demand decreased. For the demand curve to remain flat, we'll need to have a much colder than normal winter.

Crude: Chinese demand has come in lower than expected for about 6 months now. For the 2Q this year, the IEA said that demand in China was down 1% from the 2Q of 2004. Yes, that's right, Chinese demand didn't just having slowing growth, it declined on an absolute basis. Chinese refineries are now net exporters of refined goods like diesel fuel and heating oil. Crude oil inventories here are at 5 year highs.

Test time. If you look at any chart with a parabolic rise from the past, they always return to Earth. Now, without knowing what chart he's looking at, give Jeff a chart of oil and see what he says. Mix it in with a chart of '80 gold up , '73 and '80 oil, nasdaq '00 or nat gas '80 and see if he doesn't fluff it off as a bubble spike that only fools would buy into. Ah, but this time its different. ( OOPS, said those nasty words again ). I thought M. Friedman had firmly established in the 70's that markets will rush to supply shortages in markets and thus he was proved right when oil collapsed after the 80' spike. Yes, people have begun to understand the boom then bust cycles inherent in commodities.

1) Two different topics: A top in energy, and a top in energy stocks. They are not the same thing.

2) You (Jeff) state that it's the press that is saying stay away. But you conveniently left out the next line of the article after "Don't", which reads "That's the message of many financial planners and analysts..." It's not the press that is suggesting a top in energy stocks, but rather a group of money managers and analysts.

"I thought M. Friedman had firmly established in the 70's that markets will rush to supply shortages in markets and thus he was proved right when oil collapsed after the 80' spike. Yes, people have begun to understand the boom then bust cycles inherent in commodities."

Which would be true, expect for some reason none of the major players are investing in finding more of this particular commodity. They are kicking back money to shareholders. Where exactly is future supply going to come from? We have a good idea where increases in demand will come from, but how will that be matched with supply?

In my view, I am bearish on production from VZ and all the reports I read about Saudi fields intimate that they are internally worried about their reserves. I just want to know where the supply will come from to bust the oil cycle.

In my mind a real decline in demand in the US depends more on interest rates than on the price of oil. As long as consumers have easy, cheap access to credit, I think they will tend to take on more debt to sustain their life style.

I hear a lot about people trading in SUVs, but personally, I don't know anyone who has done it, or is seriously thinking about it.

Not an original point, however, needs to be stated again here: we have a refining shortage, not an oil shortage.

This is absolutely a top because we have high prices and high inventories. Remarkably, with all the lost production of oil and gas and refined product, inventories have stayed higher than expected (name your category OECD, US Natural Gas, Gas, Heating Oil). I am sure there is some lag here and the numbers may miss some data in the confusion, however, when US refinery capacity comes on line look out.

As gvtucker notes there is also demand destruction. Remember this is a game of inches, all it takes is for everyone to dial back the thermostat 1 degree and do 1% less driving.

Oil couldn't set a new high post Katrina. We have shut in production of 1.5mmb/day in the GOM for longer than anyone thought and oil is flat. How is that bullish?

I don't see demand growth as being a given. Nonetheless, there are potential sources of supply out there. Off the top of my head:

First, natural gas: On the domestic front both the Barnett Shale and the Piceance Basin are really hot these days. Farther afield, the Mackenzie Delta isn't too far off sending several BCF down our way. New off shore fields in places like western Africa and Papa/New Guinea also hold the potential for TCF-sized fields that hold the potential for significant LNG supplies. Heck, it wasn't too long ago that companies were building methanol plants just to use up natural gas that was drilled because it wasn't economic to go the LNG route.

For crude I don't see any supply constraints like gas has. Russia still probably holds as much reserves as Saudi Arabia. Off shore drilling in Africa has yielded excellent results, too. I would imagine that ANWR drilling is more palatable to a lot of people these days, too. Plenty of reserves are offshore of Florida and California, and if prices stay this high, I would betcha that the citizens in those respective places would be a little more willing to allow drilling.

Yes, I know that there's a ton of political risk. Seems like there always is. People only talk about political risk at the top. They seem to forget that corrupt governments can be just as greedy as any other government.

Good point, GV. There are always reasons people find to rationalize why its different this time. It isn't. Its a classic boom for oil in its cycle which probably will be followed by a long bust phase. Speaking of foreign areas, nobody talks about China finding reserves of its own. Obviously, Western geologist aren't permitted there but I'm sure they have plenty. China's a big place. Also notice how guys like my hero, W. Buffett refrain from playing the commodity markets when it looks like easy money. Why? Because history has shown that these booms are inevitably followed by a prolonged bust period. Clearly, Buffett isn't going to play the guessing game on calling a top in the cycles. ( yes, he did have a position in Petrochina, but its insignificant to BRKA's portfolio )

gvtucker: regarding your comments about crude supply constraints - you might want to add to your consideration the growing capacity of the oilsands projects in Alberta Canada. The oilsands reserves are expected to rival the Saudi oil fields. Granted, the process to get at the oil is more complicated and costly. But approximately C$100 Billion in projects have been earmarked for the Alberta Oilsands, over the next 10 years by the biggest oil players in Canada. It's worth a look. (C$100 Billion is approx. US$83 Billion at a 1.2 exchange rate).

Jeff: Regarding your point about Venezuela, if I remember correctly, Harvest Natural Resources (ticker HNR) is currently experiencing the exact problem you mentioned in today's post. The Venezuelan government is after the company for back taxes on oil-related profits. HNR is suing in court to fight the allegation, and it should be interesting to see how the story develops over the next several months.

Note - I do not own shares in HNR.

I don't think there's a top in oil either, IMHO. The top will only come when ALL the oil and gas companies stop spending their excess cash flow on dividends and stock buybacks (see Jeff's previous post this month on BP) and start up the capital budgeting for oil and gas exploration and production. Only then will you begin to see "the beginning of the end" for higher oil and gas prices. I could be wrong, though...

Ignore China at your own peril. China has gone from net exporter of crude oil to net importer in the past decade and their thirst for oil will only become greater.

http://www.iags.org/china.htm

The world is experiencing its greatest industrialization ever, which will play out over the next decades. I’m probably looking at this energy market with a much longer investment horizon (decades) than most, so I’m actually hoping for a pullback then I can add to my positions.